S&P Sued By U.S. For $5 Billion For Role in Crisis, But What About the Federal Reserve?

On Monday the justice department filed civil fraud charges in a $5 billion lawsuit against the largest credit-ratings agency, Standard & Poor’s. The firm has been accused of deliberately inflating the ratings of mortgage-backed securities at the heart of the 2008 financial crisis.

It was about time someone paid. Moreover, it is beyond argument that S&P was misleading investors about the quality of these hot potatoes. Nobody doubts that these inflated credit ratings by S&P, and other agencies Moody's and Fitch helped implode the economy in 2008.

But let’s try to draw the whole picture: Where did the moral hazard begin? Who else should be investigated? Was there anyone else in the link feeding the ratings agencies’ incentives to cheat? What is really at stake with this lawsuit? And finally, should the government be the right entity to frame and cook Standard & Poor’s?

In a perfectly competitive market, participants are allowed to move freely, yet within the boundaries of the fair game. The rule of law is a key element for the free markets to function and thus, rent-seeking activities must always be impeached; otherwise we’d have anarchism. The judicial system has a very important role safeguarding the integrity of an economy based on free flow of capital. Therefore, if agents are caught in flagrante delicto, they must pay the consequences of their actions. Cases of corruption, cronyism, fraud, and anyone that is bypassing the rules of the game must be prosecuted.

In this ideal scenario — which I totally subscribe to — SP should be investigated, along with all its accomplices in the scheme, e.g. banks that were born just to take on subprime mortgages, pass on the hot potatoes elsewhere, then shut down and disappear (but not before making millions of dollars with the scheme). Thus, even the weakest link in the chain should be called in.

Be that as it may, the American way couldn’t be any further from this ideal scenario. On the contrary, it exhibits a system with huge distortions. In fact, official institutions planted the initial seed: in the wake of the dotcom bubble bursting, Federal Reserve chairman Alan Greenspan lowered interest rates to 2% or less for two years. So, before pointing fingers, we ought to look at the fundamental problem, which is the distortions of the markets.

First, the Federal Reserve has functioned as a lender of last resort for anyone who qualifies as “too big to fail.” Thus, the Fed has systematically diluted the risk and sparked the initial moral hazard. Banks and financial institutions could engage in endless risk.

Second, by having a pseudo-monopoly, (i.e. only three main rating agencies: S&P, Moody’s, and Fitch) the government has become the big brother of these cronies. Whatever these agencies said or endorsed was not a product of perfect competition. It is true that they had a huge incentive to cheat due to the impressive profits from rating those toxic assets. But if there were true competition, with a dozen of such agencies, the profits would have been spread around and equalized downwards, minimizing the incentives to cheat.

Third, and what is worse: if the Fed announces that there is no such bubble, they become the bigger accomplice of such phony ratings. Moreover, whether the failure by S&P amounted to a crime is a matter of debate, because no other entity— including America’s federal regulators — did any better. In fact, by officially denying the bubble, wasn’t the government offering a similar “rating” about the overall situation? From that viewpoint, isn’t the Fed also cheating and lying over the same spilled milk and in the same fashion of S&P?

Fourth, by inducing populist reforms of housing for every American the government artificially boosted a fake demand for housing. Moreover, the “no down payment” lending policies, and the ridiculously low interest rates inflated the bubble even further and heated up the whole process.

Fifth, what can you really prove? Isn’t everybody free to give an advice? Moreover, for several years, the ratings agencies have defended themselves successfully in civil litigation. Why? Simply because the ratings were offering independent opinions, protected by the First Amendment, which guarantees the right to free speech. So, investors were led to believe something that was not true. But how can it be proved that the cheating really took place? I’m afraid that this could be a total waste of time and resources. Instead, we should redirect these resources into re-engineering the blemishes of the financial system.

Finally, everybody around the world is watching your every move. If the judicial system goes after S&P but leaves its accomplices untouched, it will prove its bias. That may generate awful unintended consequences and will send a terrible signal worldwide. The entire institutional scheme will be hurt and exposed. America cannot afford this. Not today. What may happen in the long run is to witness a great deal of uncertainty and investors may even drop their projects in America.

My concern is that this action may backfire. If the market distortions that fueled the meltdown were initiated from government action, how could the initiator accuse his accomplices of wrongdoing? As we say in my home country: “Don't blame the pig, blame the one who scratches his back.”